Buffett's vote of confidence in B of A, US economy

The Oracle Omaha says it himself: The bank and the country are going to make it. The world isn't going to end.

By RPrichard Aug 25, 2011 3:40PM

By Michael Brush, MSN Money

 

In my column a couple of days ago, I suggested that Bank of America (BAC) looked like a buy because fears about the stock -- and beaten-up bank stocks in general -- seemed overblown. This isn’t the financial meltdown of 2008 all over again.

 

Banks in general -- and Bank of America in particular -- have a lot better financial strength now than they did back then, with a much lower risk of failure. This, alone, suggests banks look like good buys.

 

Looks like Warren Buffett agrees.

 

There was a little 2008 déjà vu in the news that Warren Buffett stepped in to shore up the capital base -- and most importantly, the reputation -- of B of A. In the deal, Buffett will buy $5 billion worth of preferred stock, and collect a 6% annual yield. The Oracle of Omaha made a similar move during the depths of the financial crisis by arranging a deal to purchase preferred stock in Goldman Sachs (GS).

 

But  this isn't a case of a $5 billion capital infusion shoring up the balance sheet of a bank that might otherwise have failed. While it's a big chunk of change, $5 billion isn't really that much for a bank that has $400 billion in cash and $1 trillion in deposits.

 

Instead, this is more about Buffett examining Bank of America and concluding, as I and many other analysts did earlier this week, that the bank just isn't going to blow up and disappear -- despite what the nabobs of negativism are saying. Today's deal is more about Bank of America getting the Buffett seal of approval that the cash.

 

"Bank of America is essentially paying to get the endorsement of Warren Buffett to improve their reputation," says Michael Yoshikami of YCMNET Advisors, ranked among the top 100 independent financial advisors by Baron's. He estimates that one or two percentage points of the 6% yield on the preferred stock Buffet gets is for "the implicit endorsement that Buffett is making, and Bank of America needs a dose of credibility right now." Bank of America shares reacted strongly to the news, gaining 10% today, following a nice reversal Tuesday.

 

Banker of last resort

Make no mistake, Buffett's stamp of approval does not come cheap. It's a typical opportunistic Buffett deal. "He's really the bank of last resort, and he is using his brand name to leverage a better deal," says Yoshikami. That 6% yield is a great payoff in today's low interest rate environment. Buffett also has an option to buy 700 million shares at $7.14 over the next ten years.

 

There are two key investment lessons in this. First, you can take the deal as a bet by one of the smartest investors around that Bank of America shares will be trading for more than $7.14, going forward. Sure, there will be ups and downs, but this is a bet by Buffett that the stock will be significantly higher over the medium term.

 

Next, big picture, you can also take Buffett's Bank of America deal as an endorsement of the overall economy. After all, the disaster scenario for Bank of America was that it would not survive because a prolonged recession is on the way. The fear was that this would blow up the mortgage market, to which B of A remains greatly exposed.

 

Through his deal Thursday, Buffett is saying this won't happen.

 

And in case you're having trouble getting the message, he's also stating this straight out. "It's a vote of confidence not only in Bank of America, but also in the country," Buffett said in a CNBC interview today. "All those people who think the world is going to end, I think they're wrong."

 

At the time of publication, Michael Brush did not own any shares mentioned in this column. Brush is the editor of Brush Up on Stocks, an investment newsletter, where he has suggested readers consider buying Bank of America.